ECON 1BB3 Chapter Notes - Chapter 13: Loanable Funds, Real Interest Rate, Government Budget Balance

5 views5 pages

For unlimited access to Textbook Notes, a Class+ subscription is required.

Chapter 13 A macroeconomic theory of the open economy
Learning objectives
Build model to explain an open economy’s trade balance and exchange rate
o Analyze effects of government budget deficits
o Analyze macroeconomic effects of trade policies
o Analyze political instability and capital flight
Net capital outflow: flow of loanable funds abroad
Market for foreign-currency exchange coordinates people who want to exchange the domestic currency
for the currency of other countries
The market for loanable funds
All savers go to this market to deposit savings, and all borrowers get their loans here
There is one interest ratereturn to saving and cost of borrowing
S = I + NCO
Saving = domestic investment + net capital outflow
In an open economy, national savings does not have to equal domestic investment
If saving is insufficient to buy domestic capital, the shortfall can be met by savings of foreigners
o NCO is negative
Demand for loanable funds comes from domestic investment (I)
Real interest rate determines quantity of loanable funds supplied and demanded
o Higher real interest rate, more people save, more supply
o Higher interest rate also makes borrowing more costly, less demand, discourage
investment
In a small open economy with perfect capital mobilitywe ignore differences in tax treatments
and default risk r= rw
In a small open economy, we need to include savings of foreigners
When S is able to satisfy domestic I, the excess money supply can then use to buy foreign assets
The excess money is NCO
If S is unable to satisfy domestic I, the excess demand for loanable funds be gained from foreign
investors (capital inflow)
Interest rate in open economy is determined by world interest rate (r = rw)
Ex: want to buy Japanese government bondmust first exchange CAD to yenssupplies dollars
in a market for foreign-currency exchange
Net exports = quantity of dollars demanded for buying Canadian net exports of goods and
services
If Japan wants to buy planes made my Canada, it must first DEMAND dollars in the market for
foreign-currency exchange
Real exchange rate: balances supply and demand in the market for foreign exchange rate
Unlock document

This preview shows pages 1-2 of the document.
Unlock all 5 pages and 3 million more documents.

Already have an account? Log in
o Relative price of domestic and foreign goods
o Key determinant of net exports
o High real exchange rategoods become more expensiveless exports
o Appreciation in real exchange rate means reducing quantity of dollars demanded in the
market for foreign-currency exchange
RER equilibrium
s
equilibrium quantity
D
Net capital outflow does not depend on exchange rate
Higher exchange value of CAD make foreign goods less expensive for Canadian buyers, and
makes foreign assets less expensive
o But Canadian investors eventually want to turn foreign assets back to CAD
Changes in exchange rate influence both cost of buying and benefit of owning foreign assets
o Offset each other
Equilibrium real exchange rate: demand for dollars to buy net exports balances supply of dollars
to be exchanged into foreign currency to buy assets abroad
Ex. Canadian residents buys car imported from japandecrease in quantity of money
demanded due to fall in net export
Ex. Japanese buys Canadian bond decrease in quantity of dollars supplied due to fall in net
capital outflow
Net capital outflow: link between two markets
In market for foreign-currency exchange, supply comes from net capital outflow, demand comes
from net exports, real exchange rate balances supply and demand
The real exchange rate does not affect net capital outflow, supply curve is vertical
NCO determines supply of dollars to be exchanged into foreign currencies
Demand curve represents demands for dollars comes from net exports
Unlock document

This preview shows pages 1-2 of the document.
Unlock all 5 pages and 3 million more documents.

Already have an account? Log in

Get access

Grade+
$10 USD/m
Billed $120 USD annually
Homework Help
Class Notes
Textbook Notes
40 Verified Answers
Study Guides
1 Booster Class
Class+
$8 USD/m
Billed $96 USD annually
Homework Help
Class Notes
Textbook Notes
30 Verified Answers
Study Guides
1 Booster Class